Mike Crane is an audit senior of a large public accounting firm who has just bee
ID: 2464871 • Letter: M
Question
Mike Crane is an audit senior of a large public accounting firm who has just been assigned to the Frost Corporation’s annual audit engagement. Frost has been a client of Crane’s firm for many years. Frost is a fast-growing business in the commercial construction industry. In reviewing the fixed asset ledger, Crane discovered a series of unusual accounting changes, in which the useful lives of assets, depreciated using the straight-line method, were substantially lowered near the midpoint of the original estimate. For example, the useful life of one dump truck was changed from 10 to 6 years during its fifth year of service. Upon further investigation, Mike was told by Kevin James, Frost’s accounting manager, “I don’t really see your problem. After all, it’s perfectly legal to change an accounting estimate. Besides, our CEO likes to see big earnings!”
Answer the following questions in the Discussion Board:
What are the ethical issues concerning Frost’s practice of changing the useful lives of fixed assets?
Who could be harmed by Frost’s unusual accounting changes?
What should Crane do in this situation?
Explanation / Answer
1) The ethical consideration is that the useful life of the assets could be changed so that in future periods there are higher earnings. Once the useful life of the assets has been exhausted, the company will not have depreciation expense. That could significantly increase earnings.
2) Investors could be harmed by Frost's change. This is because the company's profits are being manipulated by accounting estimates. When the earnings are higher, the value of the company will go up, but once new fixed assets are purchased and begin depreciation, the earnings will plummet.
3) Crain should require Frost to use useful lives that mirror the estimated life of the asset. If a change is made, it should be because the asset's life is decreased (such as equipment coming obsolete), not just an arbitrary change. IF Frost refuses, Crain can give a qualified audit opinion, or an unqualified opinion with an explanatory paragraph outlining the depreciation issue.